Currency volatility needs to be monitored closely as offshore rupee trade begins
Jan 07 2013, 2123
For foreign institutional investors (FIIs), currency hedging is risk management and a dynamic operation to defend returns. But FIIs are not permitted to hedge in the domestic foreign exchange market, and are instead expected to assume currency risks. This is because it is argued that hedges by portfolio investors could lead to high volatility in currency values and complicate domestic management of the economy. Besides, like the Chinese renminbi yuan, the rupee is not a fully convertible currency. While FIIs may not be too worried about the macroeconomic conditions, their primary concern is to maximise returns to their fund investors. Therefore, most of them create offshore non-deliverable forward market for hedging non-convertible currencies that include the yuan and the rupee. However, the NDF hedge is not exchange-traded, but an over-the-counter (OTC) product. Settlements in NDF markets are in US dollars, the price of which provides cues for the rupee’s movements. A high price for the dollar in the NDF market indicates outflows and vice-versa. Will introduction of rupee derivatives result in displacing OTC trade in NDF markets? That appears unlikely since NDF markets serve FII hedging. However, there could be some arbitrage movements or taking advantage of different rates in various time zones. The Dubai Gold and Commodities Exchange that introduced rupee futures in 2008 had hoped to grab some share of the rupee trade. Yet the NDF markets have continued to grow. The DGCX rupee futures platform is almost entirely used by non-resident Indians in West Asia and very rarely FIIs. But the introduction of more platforms in rupee trade in Europe and the US serves those time zones, widening hedging opportunities for big-ticket deals. It also means that the rupee would become internationally liquid by default even without full convertibility. FII gains are from both asset value increases and domestic currency appreciation. What that means is that FIIs would be in a position to bring in large amounts of capital, driving up markets and exchange rates. If the hedging is at the highest exchange rate, their gains are maximised. On the flip side, it could mean that exchange rate volatility would substantially increase each time capital flows out. Capital movements have already increased volatility. Right now, two-way volatility in the domestic market is about 11 per cent against barely 5 per cent two years ago. So FIIs would be in a position to fully maximise trading opportunities. But large flows of capital from portfolio investors are fraught with risks, since it could strip exporters of their gains or inflate import costs and even escalate debt service payments. It also means that Indian companies that had hitherto left their foreign currency debt unhedged would also have to begin active risk management. It would also limit the ability of the RBI to intervene in the exchange markets, in view of its limited foreign currency reserves. At present, even small amounts of RBI intervention are sufficient to curb volatility. However, it is questionable if RBI would be able to respond effectively in an environment of large portfolio capital flows. Already RBI is faced with the three-fold problem of inflation, liquidity and exchange rate management with its low reserves. Therefore, more capital flows from foreign sources may appear good. Having said that, we need to remember the 1997 South East Asian currency crisis when speculators almost wiped out the foreign exchange reserves of Thailand and Malaysia. India was insulated then. That environment has changed since, and India could face a similar currency crisis if regulators and monetary authorities drop their guard.